A maximum price is the highest price that can be charged for a product. It is fixed below the equilibrium price. This is usually used by the government to make a product affordable because the market price is too high. A maximum price is a price control used for essential products such as staple foodstuffs and rent. It is also known as a price ceiling as consumers cannot be asked to pay higher than it buy they can be charged a lower price. It creates a problem of shortage or excess demand as the quantity demanded increases at the lower price while the quantity supplied decreases. This often leads to queues or the adoption of waiting lists by businesses. In the long run, the suppliers may be discouraged from offering the product unless the government does something about it. In addition, it may be difficult to attract new investments. For instance, the use of rent control will eventually make landlords use their houses for other purposes apart from renting them out.
Figure 1: Maximum price
The quantity demanded Qd exceeds the quantity supplied Qs (shortage) due to the imposition of a maximum price below the equilibrium price P. The quantity traded in the market is Qs as the consumers cannot buy more than the quantity Qs offered by the suppliers. This means that not every consumer can obtain the good. The government may have to ration the goods by distributing a fixed amount to each individual to ensure everyone has access to the good. If the government does not intervene by rationing, firms will give preference to their loyal customers, thereby preventing others from having access to the good. A black market may develop where the goods are sold above the maximum price; because of the scarcity, some consumers may be willing to pay more than the original equilibrium price P.
If a buffer stock scheme is in place, the government may release some goods from the buffer stock. It may also intervene through direct provision, granting subsidies or tax incentives.
The effect of maximum price on welfare
Figure 2: Maximum price and welfare
Maximum price and consumers’ welfare
The consumers pay the maximum price P1 which is lower than the equilibrium price P. The initial consumer surplus is the area of triangle JPL. The new consumer surplus is the area of trapezium JP1KN which is bigger than the initial consumer surplus. This means that the welfare of the consumers has improved. KML, part of the initial consumer surplus is lost while PP1MN, part of the initial producer surplus is gained by the consumers as part of their new surplus.
Maximum price and producers’ welfare
There is a loss of producer surplus and welfare as a result of the introduction of maximum price. The initial producer surplus is shown by the area of triangle POL. But the new producer surplus is P1ON which is smaller than the initial producer surplus. The lost surplus of the producers is the area of trapezium PP1LN.
Maximum price and economic welfare
The overall loss to the economy is represented by the triangle KNL. This is also called deadweight loss. The quantity traded Qs is less than the optimum quantity, i.e. the equilibrium quantity Q. The desired production or consumption does not take place resulting in welfare loss to the society.